Blogs: Lewis E. Lehrman

In the absence of government prohibitions and restrictions in favor of inconvertible paper and credit money, history shows that gold—or paper and credit money convertible to gold—was preferred and accepted in trade and exchange from time immemorial. Until recent times the gold standard also underwrote, indeed required, the trade rebalancing and equilibrium mechanisms of the international economy. In the absence of prompt balance-of-payments settlements in gold, the undisciplined official reserve currency systems have immobilized the international adjustment mechanism with the result being increasing trade imbalances, debt and credit leverage at home and abroad. For example, under the world dollar standard, other nations gain desired dollar reserves only as the United States becomes an increasingly leveraged debtor through balance-of-payments deficits; whereas under the gold standard, the global economy may actually attain balance-of-payments surplus as a whole vis-à-vis worldwide gold producers.

The true gold standard—without official reserve currencies—is the sole, rule-based monetary order which reliably and systematically rebalances worldwide trade and exchange among all participating nations.

In 2012, inflation proceeds gradually in the United States because of unemployed resources. At full employment, inflation accelerates. But then, as the Fed and the banking system reduce the growth rate of credit, the threat of deflation will reappear (as in 2006-07 and 2012). Because the reserve currency system generally leads to a rapid increase in global purchasing power without a commensurate increase in the supply of goods and services, the systemic tendency of the reserve currency system is inflation—generally in the prices of investment assets, commodities, and speculative vehicles like art and antiques. Yet the process can dangerously work in reverse, causing deflation, especially when the Fed tightens, or there is panic out of foreign currencies into the dollar (the Asian Crisis, 1996-2002, and the Euro Crisis—2012). Illiquidity abroad causes foreign official dollar reserves to be resold or liquidated in very large quantities, reducing the global monetary base—as occurred in 1929-33 and recently in 2007-09.

Since 1971, the floating, world dollar standard has been even more perverse and crisis-prone than the reserve currency systems of Bretton Woods and of the interwar era. Indeed, the privilege and the burden of the dollar’s role as the world’s official reserve currency has been a cause not only of extreme inflation and the threat of deflation, but also of industrial and manufacturing displacement in the United States. The world dollar standard is a primary cause of declining U.S. competitiveness, a witness of which is the collapse of the international net investment position of the United States. In 1980, the U.S. net international investment position was 10% of GDP. In 2010 it was negative 20% of GDP. The difference was equal to the increase of foreign-held official dollar reserves, arising from continuous U.S. balance-of-payments deficits.

Under the official reserve currency system based on the dollar, the perennial U.S. balance-of-payments deficit will, more often than not, continue to flood foreign financial systems and central banks with undesired dollars—followed by brief periods of dollar scarcity, the threat of deflation, and a cyclical rise of the dollar on foreign exchanges. Foreign monetary authorities will continue to purchase excess dollars against the issue of new domestic money, thus duplicating potential purchasing power unassociated with the production of new goods—tending to sustain worldwide inflation, followed by recession and the threat of deflation. So-called sterilization techniques designed to neutralize foreign exchange inflows are not fully effective. Without monetary reform, the excess dollars purchased by foreign central banks—reinvested in U.S. government securities and other dollar claims—will continue to finance excess consumption and rising government spending in the United States.

The Bretton Woods pegged exchange rate system, based on the official reserve currency role of the dollar, collapsed in 1971 because the United States had accumulated more short-term debt to foreigners than it was willing to redeem in gold. The collapse of the Bretton Woods system, based on the official reserve currency role of the dollar, ushered in the worst American economic decade since the 1930s. The unemployment rate in 1982 was higher even than the unemployment rate occasioned by the collapse of the Fed-induced real estate bubble of 2007-09.

Similarly, the recession of 1929-30 became the Great Depression of the 1930s because of the collapse and liquidation of the interwar official reserve currency system—based as it was on the pound and the dollar. The liquidation of official sterling and dollar currency reserves deflated the world banking system because without those reserves the banks were forced to deleverage, call in loans, or go bankrupt. Banks worldwide did all three.

The rule-based true gold standard not only ends the official reserve currency role of the dollar, but it also limits arbitrary Federal Reserve money issuance secured by defective and illiquid collateral. Unstable mutations in the true (or classical) gold standard of the past—including the failed “gold-exchange” system of Bretton Woods and the collapse of its predecessor, the “gold-exchange standard” of the 1920s and 1930s—must be ruled out. So, too, must floating exchange rates. For almost a century, policy makers, politicians, historians, and economists have confused the flawed interwar gold-exchange standard, based on official reserve currencies, with the true or classical gold standard. Led by Ben Bernanke and Milton Friedman, economists have mistakenly blamed the Great Depression on the gold standard, instead of on the liquidation of the gold-exchange system and the official reserve currency system established at Genoa in 1922-40.